Understanding Switching Costs: A Key Competitive Advantage

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2:18All right, folks. Welcome to Investing for Beginners podcast. Today, my friend Brett and I from Chit Chat Stocks are going to talk about switching costs. Last time we talked about network effects. This time we're going to talk about switching costs as a moat. So Brett, welcome back to the show again. And let's talk some switching costs. Yeah, glad to be back. Talked to network effects. Today we're talking switching costs. And I'm sure we're going to eventually cover the other two of the big four competitive advantage categories or remotes, which also include as a teaser, and people can go research some of the stuff themselves, economies of scale, and brand slash intangible assets such as patents.

3:03Kind of relevant today, as we're in the midst of popular stock Hims and Hers and Novo Nordisk getting into quite the battle over intellectual property, patents, and all that good stuff. But yeah, let's talk switching costs, otherwise known as the power of inertia in everyone's daily life and business life. And this is one of my favorite moats, my favorite competitive advantages, because it has turned into some really good stocks over the years. You got Microsoft, you have banks, although, Some of them haven't done that well lately, but durable franchises over the long term, tons of other software providers, telecom, there's a lot of ways that switching costs can turn into a great business, even though some of these same companies might be the ones that listeners, individuals, customers can get frustrated with in their everyday lives, but maybe something that doesn't make sense, you know, it's counterintuitive, but if it's so frustrating in your everyday life to use, but you can't leave, well, that might mean they got a little bit of monopoly going there.

4:17And, you know, that can lead to pricing power and good profits. Yeah, for sure. For sure. So if you had to, if you had to define switching costs, I think you kind of outlined it a little bit there, but if you had to define it, what would you say it is? So the switching cost is if we're going to switch, let's say we have an existing product or service we use or that you buy or what have you. You have an existing relationship and it's going to cost you some sort of value in either time, money, or frustration to get an equivalent product. And the larger that is, the more time needs to be spent, the more employee frustration, the more employee hours, and the more money that needs to be spent to switch from this existing service, to rip and replace and fill in another product in its stead, that is the wider competitive advantage.

5:17I think that about sums it up. Yeah, I definitely would say that. So you mentioned the whole, it's not just financial, but time. What does that really mean? I think it means if you're an individual, so there's difference between business to consumer. So, say, as a listener in their everyday life, their personal spending habits, there's a difference between that and then B2B. Maybe we can go through both examples. It is really just how much time and frustration it takes to switch or how much of data is built on this one platform. For example, one that comes to mind for myself is a music streaming service such as Spotify.

5:58when you look at the start of using a music streaming service Spotify Apple Music YouTube Music what have you they all have the same amount of music they all work with the labels they all work with the independent distributors the existing catalog is the same but as you build out your playlist as you build out the relationship with the platform as they build their discovery playlist especially with Spotify and all the different things that add on with that that can create a high switching cost in moving. Now, there might be some service that can port it over for you, but if it takes hours to replicate the exact same service, that is a high switching cost.

6:39And Spotify might not have the largest switching costs in the world, but it can. It can have, you know, quite high one. And if we're looking at B2B or say a software program, the best example would be, I think, of all time, Microsoft Excel, especially for listeners in the investing, finance, accounting world. If you were going to take Excel out of your existing workforce, especially for a larger business, and replace it with something cheaper, for example, Google pretty much gives away Google Sheets for free or an extreme discount to what Microsoft offers. And a lot of people that are starting out, you know, including myself, younger, don't work for a large organization.

7:26I use Google Sheets. I think it's a fairly equivalent product. But if you're already been using Microsoft Excel for 10, 20 or 30 years, you have so many existing files, you have so much of your organization's data, charts, analysis, all the different departments working with Microsoft Excel under the Office 365 subscription. If you wanted to replace that from a time spent perspective, it would turn into from employee hours that would convert into such a large expense for your business that it's un-economical to switch, even though Google Sheets or an equivalent is significantly cheaper if you were starting from scratch.

8:08Yeah. Yeah. It's significantly cheaper. And I think it really comes down to like how sticky the ecosystem is for for those products like you were describing spotify i was thinking i back in the back in the day i used to use apple itunes and before i switched to to spotify and i remember going through my playlists and albums and trying to find you know some unforgotten album on my iTunes, could I find it on Spotify? And how many hours I spent doing that. And now that I'm fully entrenched in the Spotify ecosystem, I'm not leaving, you know, unless, you know, even if the, you know, even as they continue to keep raising the prices, I'm still not going to leave because I, A, I don't know anything better out there to replace it.

9:02And And B, the time value to me is not worth it to give it up. And I just wouldn't do it. And in the kind of the same, I guess, example, in the business world, when I was working in the restaurant business, a lot of the small businesses that I work with, all the small restaurants that I worked in, they all use QuickBooks for their accounting. And there was nothing. I mean, there are other programs now, but they were all trained. All the accountants that worked at the restaurants were all trained on QuickBooks. They all knew it inside and out. They had all their files in there, all their systems, all their processes, and they were not leaving QuickBooks to go to another platform, even if it was easier or cheaper.

9:46They just, they weren't leaving because they were so ingrained in that ecosystem. And it just made a very, very, it was very obvious to me that that was a very high switching cost for something like QuickBooks. Right. Yeah. Two follow-ups there. One, the connection to stock returns is that if you have that high switching cost, for example, QuickBooks, more expensive, but people are sticking with it because it's not going to kill the profitability of the entire restaurant. It's not a huge cost in the overall chain of the restaurant's cost. I mean, you're worried about labor and food costs and managing, you know, volume and all that stuff.

10:23That gives a software program like QuickBooks the ability to raise prices. And that can lead into earnings and cash flow growth, which over the long term is going to translate into stock price appreciation as long as you buy at a reasonable price, of course. And the second one is that, you know, iTunes, as you mentioned, did have high switching costs back then. And the big risk to a high switching cost business is when there's an entire paradigm shift in the industry for how people consume. So, Spotify, Big Paradigm Shift, the music streaming model, that threw a wrench into everything. And that's why I think people are either excited or concerned or just paying high attention to artificial intelligence and AI when it comes to switching costs with software where you have, okay, well, today, if Google Sheets can build, you know, basically a copycat of Excel, well, no one's going to switch even if it's at a cheaper price.

11:22But if they can fundamentally change, I don't know if they can, I don't know if this is possible, the spreadsheet business, while Microsoft can't, well, that could lead to more customer attrition because you're getting a much higher ROI by using Google Sheets. Same thing with Adobe in, I'm not an expert on, you know, the editor stuff and kind of the, what it'd be, video and graphics and marketing and stuff like that. if AI can fundamentally change how those processes work, that could leave an opportunity for people to step in and disrupt Adobe. Not saying they will. It's just when there is potentially a huge shift in the industry, that switching costs can erode because instead of just, you know, the incumbent has to have the ability to copy the existing service without ruining their existing business model and showing like the difference between iTunes, which did have high switching costs versus Excel, like that spreadsheet business has essentially been the same for a long, long time, just with added features that illustrates how, you know, switching costs in all modes are not impervious and they're going to get attacked over time.

12:32And it kind of just depends what sort of business you're in, how the sector is doing and what's evolving in that in that product yeah so what what kinds of like if we think about the impact that ai could have on some of these businesses you know i think about you know i think about the spreadsheet part of the business could you know the agentic ai or ai agents or however you want to phrase that do you think some of that could be coming for those kinds of things or is that something you don't really think about much i think it definitely could i don't follow the i don't follow microsoft that much i do follow google but that's such a small part of the business i really care about other things i think it could specifically look at them though i i would guess that within the spreadsheet business within the say not just spreadsheets but you know the office suite that google also has copied with google workspace i would assume that Microsoft could copy any Google innovation and Google could copy any Microsoft innovation within that.

13:39But one that I think illustrates the big threat that this is more of a consumer one, which is Google search with, you know, Android, the default distribution with Apple, Chrome, Gmail, Maps, all the stuff that kind of is around Google search that makes it much historically much better to use compared to, you know, the copycats that might still have good search results but are not a part of the whole Google ecosystem. The chatbots of OpenAI have shown that OpenAI and others that Google's had to respond to have shown that even though there's high switching costs, I think that's just another paradigm shift.

14:16And maybe Google has the ability to copycat whatever OpenAI does and improve on it, but that's kind of the threat they're facing. And I think, you know, a lot of the switching costs business, I believe, and maybe this is what I focus on is software technology, the cloud infrastructure providers, even someone like NVIDIA has high switching costs given the software layer on top of that that developers use. AI is throwing a wrench in the mix and maybe could benefit some companies and hurt others and there's just a lot of uncertainty at the moment. And as I like to talk about and I think it's a good framework for identifying and analyzing moats for businesses is what is called a moat test.

14:58So you believe that, for example, Google Search or Microsoft Excel, two phenomenal businesses, you think they have wide moats. Now they're getting attacked by a new competitor. They're going for these gigantic cash cows and we'll see if it can hold up to this battle. The more I've gotten to learn about Bitcoin and start to dip my toes with it, the more I realize some of my preconceived notions were incorrect. For example, I don't have to be all Bitcoin or all stocks. I can learn very instructive lessons about assets, currencies, and investments from the very long-term history of the world, and I don't have to be a speculative trader or radical enthusiast or even somebody who frets about the volatility when I have the right tools to set up a prudent allocation for my finances.

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17:33Check your brain and health the way I do. Function provides 160-plus lab tests for$1 a day and member pricing on advanced imaging. Join at functionhealth.com slash beginners and use code beginners25 for a$25 credit what's the best way to get started in the market download my ebook for free at stockmarket pdf.com yeah a good question to ask when you're thinking about that battle is how painful would it be for the customer whether it's a consumer or whether it's a business to leave that business Like how much would it hurt for people to leave Microsoft Office to go to another product? Or how hard would it be for people to leave Salesforce and their CRM and go to another CRM?

18:22Like how hard is that? How painful is that? Right. And you might not know that like for Salesforce CRM, I kind of just throw my hands up. I don't really know. I don't know much about that industry. People say things, but it's almost like someone talking about this brand in a foreign country. is fantastic you know especially with chinese companies alibaba is fantastic there or jd.com is fantastic pinduoduo is fantastic they're all doing well apparently and then they interchange market shares and keep trying to disrupt each other and i have no idea what's happening i think this comes back to you know what is your circle of confidence what can you understand another example of potential ai disruption is we have you know hurting switching costs historically and I think still today, your cloud infrastructure provider, you had high switching costs.

19:10If you used Amazon Web Services, Microsoft Azure, Google Cloud, Oracle, some of the others, it's very hard to switch. Netflix has had a long-standing relationship with Amazon Web Services, and I think they're probably their number one customer. Maybe not, but either way, one of their largest customers. And if Netflix said, look, we'll switch from AWS to Azure, it's not going to cost that. Maybe it costs a little cheaper, but it would be an insanely risky endeavor to pull off because you're throwing your entire technological infrastructure and risking moving it to another platform. But from what I've heard or read and had some anecdotes about is that with these new AI tools and software and services and cloud stuff that companies care about, Google Cloud is able to offer superior services at a cheaper price.

20:07And that's leading a lot of startups to move to Google Cloud that are focused on AI. But as we can see, you're not seeing existing customers switch because even if Google Cloud is superior, you have AWS and Microsoft Azure that can replicate a lot of what Google Cloud is doing and they can make it so, you know, Netflix isn't going to say, let's risk our entire business to move to Google Cloud when we don't even know what the ROI is going to be. Yeah. Yeah, such a great example. If you, like, if you had to define or list out maybe some of the businesses sectors you think have strongest switching cost moats like who would you who would you put on your shortish list if you will here's what comes to mind software cloud i guess if that's a little different financials consumer financials or you know investing investment banking and also including brokerages i don't know if this isn't any sort of sponsor but on my own show we're sponsored by interactive brokers so i just want to have a disclosure that i'm not pitching that you use the product even though i do have an advertising relationship with them interactive brokers is what i think the superior service for individual investors i bought the stock i think it's a great platform i switched everything that I use from one of the legacy brokerages to interactive brokers.

21:46But it took a long time. It's kind of hard to go, how do I even do this? I got to fill out a little bit of paperwork. You know, it's online paperwork. You got to sign some stuff, make sure the transfer is going to work correctly. I've talked with other people and they say, yeah, interactive broker sounds better, but they just go, I haven't made the switch yet. So I think brokerages have, have especially if you have your retirement accounts with them all the other stuff not just if it's just a taxable brokerage you can just transfer out and you know close the account but those can have along with personal banking high switching costs as well I'm trying to think I'm sure there's stuff in sectors that I don't follow that closely but those would be the three that come to mind for me, for at least the sectors that I follow, any that popped to mind for you, Dave?

22:37Yeah, one in particular is it's along the same lines as the financial system, but it's the core banking system. So companies like Jack Henry, Fiserv, Fidelity National Information, Accenture, some of those companies that basically create and monitor the plumbing for banks. So when you think about the banking infrastructure, when you go online and do that, most of the time that's not actually done by the bank, it's done by their core provider. And tracking payments, tracking loans, deposits, all those things, the infrastructure for the ATMs, a lot of that stuff is done through the core banking system.

23:19And Jack Henry is probably one of the best examples of this. They mostly service small banks and credit unions, and their retention ratio is 93%, 95%, something ridiculous. And they have a subscription service now, and that's kind of how they do their thing is they help people, and they put the plumbing in, and then the banks pay a subscription. They get the training. They get all the help they need to run their services. but the pain that it is to leave that, to your point about AWS and Netflix, it's the same with a bank. I mean, if you pull all that out and put a new system in, there's a lot of risk to do that.

24:07And it's also a lot of training, a lot of time spent, a lot of money. And you got to think too, a lot of these systems that these banks are replacing, I haven't seen it, but I've heard that some of them are still running on like MS-DOS and stuff like that. Yeah. What's it called? COBOL? Yeah. COBOL. Yeah. EI might be able to help with this as you can learn these languages quicker. But that is some of the stuff that was, yeah, getting learned in the 60s, 70s. Right. So a long time ago. Yeah. So that's one like industry sector that really kind of springs to mind for me that is really strong. I mentioned the Salesforce.

24:46I don't work in the CRM industry much, but I was actually helping my wife look through companies to try to decide because they want to change their CRM provider. And just the amount of work that they're going through to try to do it, just to find a company that they could replace and do all the things that they want, it's been a month-long process. And they haven't even started the process of changing. And this is a small business with literally three employees and lots and lots of customers over the years. And so it's going to be a challenge. So I think there's little niches in different industries that have really high switching costs across the board.

25:31When you were talking, I got reminded of two others. First, which is just kind of a unique example subscription-wise, and that's Amazon Prime, the ecosystem they've built. it's pretty hard to leave and that as maybe we'll talk about in one episode when you have multiple competitive advantages amazon as people can guess has economies of scale they also have a bit of a network effect with the marketplace and they have the switching costs if you get multiple of them relating together that can turn into some of the best businesses in the world but a category that i think maybe it's not underrated but not followed just because it's a little bit boring payment processors you have adion you have square even though it's kind of run by some let's say eccentric people who is clovers owned by someone toast yeah stripe i guess is private and you have those there's a couple different layers in the chain that we don't have to talk about today but i especially like a company such as adion because they work with some of the large multinational consumer apps and stuff like that, such as Spotify, Uber, what have you.

26:40And they're helping them process payments efficiently and at an affordable price. And if you were going to say, well, this other company is offering us a 10 % discount, but we got to rip out our entire payment solution. And when someone tries to book an Uber and the payment doesn't go through, we could have some very unhappy customers. So, I think that, I think ad yen especially, and companies like that can have extremely high switching costs if they provide a quality service. There's quite a few, I think, subpar legacy players in that space, but that's a whole nother discussion. Yeah, for sure.

27:15And I can give you an anecdotal story about that. So when I was in the restaurant business, one of the restaurants I was working at, they decided they wanted to switch payment processors. They were going to get a better rate and a quicker turnaround on their money because generally you don't get your money when a credit card is run for one to three days depending on which card it's being run on and what day of the week and blah, blah, blah. Anyway, we switched out. They pulled out the plumbing, put in new plumbing, and it took almost a week for everything to work and for them to be able to process the payments.

27:50So not only did the technology not work, So the staff had to run all the credit cards for a week manually. So the old school sliders with the carbon paper stuff, we had to do that. We had to handwrite all the numbers in there. We had to put phone numbers on all the credit card slips. And this was a high retail, not high retail, but a high priced restaurant. And so the - Yeah, people are upset, I'm guessing. Yeah, yeah. Well, the customers, not so much. It was the staff that was really a pain in the butt for. The customers, when you explained it to them, for the most part, they were fine. But the bigger issue was that not only did the restaurant, so the restaurant actually had to go out and borrow money because their cash flow just dried up.

28:36Because of the rotating of the cash of the deposits coming in from the credit cards just evaporated for a week. They didn't have any working capital. and so to pay for the food to pay for all the stuff they had to go out and get a short-term loan to cover all this and you know i think from what i heard from management they worked they work with the pain the incoming payment processor to get some of that squared away if you will i.e they paid for some of it but still it was it was a monster pain in the butt and it was a very very clear indication of how much headache something a switching like this could cost a business.

29:15And it wasn't, you know, it's a standalone restaurant in a smaller town. So it wasn't a big operation. So to your point, if you're doing something like Uber is ripping out their plumbing to accept another payment processor, it's a big deal to go through all that. This episode is brought to you by Facebook. So you were scrolling on Marketplace and there it was, the bike you'd been searching for. You sent a message and it turned out the seller was super chatty, kind of funny, and an avid cyclist. The next thing you know, you're in a cycling crew. Well, a community cycling group. The thing about Facebook, you might find more than what you're looking for.

29:58From a browse to a bike ride, this summer, find more on Facebook. Propel Fitness Water. With Gatorade electrolytes, zero sugar, and vitamins, Propel hydrates better than water to help you get the most out of your workout and get back to your best self. What propels you? Propel with Gatorade electrolytes. I agree. Yeah, nothing to add. Nothing to add. All right. So let's talk about pricing power. You mentioned that kind of at the beginning. Why does this offer so much opportunity for pricing power and what's the big deal about pricing power? okay let me talk through this from a specific example of a software company a category we talked about but a specific company within that that has i believe some of the highest switching costs in the entire world and that would be autodesk along with some of the engineering architecture and construction software providers so autodesk is the owner we'll talk through one of the products of Revit, which is the premier, I think, highest market share software provider for architects.

31:07So you're an architect, you're doing a lot of software design on a building, all that good stuff, following the regulations. And if you are an architect, you are not only using this, you know, not everyone in the company, but for at least the specific employees that are that have a license. You're using this constantly throughout the day. You are sending files to people. It's again, similar to you in Microsoft Excel, but specifically, you know, for building architecture, it is your operating platform that you use to work with all of your customers, suppliers, what have you. Not only are you using that in your day-to-day life, but you've been trained on that at university.